Knightian Uncertainty: The Effects of Risk and Ambiguity on Excess Returns of Borsa Istanbul

Ambiguity is an important factor that is ignored in investigating the asset pricing problem in neoclassical finance theory. Risk is the phenomenon which describes the situation when future result is not known but the probabilities of future states are precisely known. On the other hand, ambiguity is the situation which describes not only the future result is known but the probabilities of the future states are also not known. The models which are based on rational expectations theory and exclude ambiguity, are insufficient in explaining some asset pricing anomalies like equity premium and excess volatility. Several empirical analyses show that ambiguity has an important potantial in explaining these anomalies. Following Brenner and Izakhian (2011) which develops a model that generates a quantitative ambuguity measure, the aim of this paper is to test the effects of risk and ambiguity on market excess returns of Borsa Istanbul in April 2003-April 2014 period. The evidence from full sample period as well as three subperiods show that risk and ambiguity have statistically significant but negative effects on excess returns. The ambiguity,as another factor along with the risk, has a significant contribution in explaining excess returns. Investors in Borsa Istanbul exhibit a risk and ambiguity seeking behavior in this period. This attitude can be explained by their optimistic behavior.